Chapter 14
Expectations Theories—Always Changing, Always Relevant

Expectations drive markets. Immediately after economic data is released traders and media outlets are comparing them to “expectations.” Intuitively it feels odd that there could be an announcement of gross domestic product (GDP) being down –2% and the stock markets trade up because expectations had been for –2.8%. However, this is the power of expectations and why expectations are often as important as the data itself. As discussed earlier, expectations about inflation can theoretically be more important than what the inflation numbers are. This is because this expectation is what impacts the consumers’ decision to spend or to save. The same can be said about expectations for interest rates and economic growth.

Where do expectations come from and have they changed over time? Typically published expectations for company or economic releases are set by a survey of analysts or economists at major banks and brokerage houses. It is worth noting that these composite expectations are not weighted by the size of the institution making the estimate, the resources they have dedicated to the task, or the historical success of those making the forecast. Importantly, the same source may be used over time (e.g., Bank A’s research department estimates) even though the actual forecaster or analyst team has changed. A factor that is sometimes ignored has been how many of these organizations that hire analysts and forecasters have changed the resources they have dedicated to pay and staff research departments that make these forecasts primarily because of government regulation. Additionally, whoever is preparing the estimates that get rolled into composite expectations all will have conscious or subconscious biases that are driving their expectations. As John Silvia, former chief economist at Wells Fargo wrote in one of his books on forecasting, “Unfortunately, analysis often starts with a view and then tortures the data until it reaches the proper result.”49

Banks are not the only source of expectations. Companies often put out their own guidance for earnings and other key performance indicators (KPIs). There are also several organizations, including government agencies, that put out economic outlooks and forecasts. These sources include central banks like the Fed and the Bundesbank in Germany as well as specific agencies like the U.S. Department of Agriculture. There are also regional federal reserve banks in the United States that publish forecasts and international agencies like the International Monetary Fund (IMF), the World Bank, and the Organization of the Petroleum Exporting Countries (OPEC) that publish macroeconomic expectations.

The reaction in markets to a “beat” or a “miss” on expectations is not often long lasting, unless it is viewed to be a change in trend. It is still the longer overall trend that ends up driving asset valuations. When there is a reaction in the short term to a result that is an outlier, if it disagrees with your long-term view it may create an opportunity for an entrance or exit into an investment. The expectations of individuals and how these expectations make them act is a fascinating field of economics. While this has been an area of inquiry for centuries, it recently had been getting labeled behavioral economics. One of the aspects of human nature is that it is hard to predict what will change someone’s view of the future. When you look at some of the major surveys about consumer confidence or inflation there are periods where it may surprise you how small or large the changes were even though the current events seemed extreme. For example, in the United States, in one survey, shown in Figure 14.1, consumer confidence dropped more during the tech stock collapse in the early 2000s than after the 9-11 terrorist attacks.

Most of the surveys about economic expectations revolve around consumer sentiment and consumer and business expectations for inflation. The Organization for Economic Cooperation and Development (OECD) releases surveys about consumer sentiment on their member countries, in the United States several regional Federal Reserve banks release surveys on expectations. There are numerous other surveys as well that can be very valuable. Surveys about confidence, economic expectations, and sentiment change rapidly. How quickly expectations change can be important. It is difficult to isolate if the proliferation of newer and faster sources of information are causing more shifts in expectations or if it is actual events that occur that cause the speed at which expectations change to accelerate or decelerate. Surveys may show changes, but in reality economic view may not change that rapidly. As Neal Soss, the vice chairman and former chief economist of Credit Suisse has said, “You don’t usually have one outlook for inflation in the morning and then after lunch completely change your view, inflation expectations take time to change.”

Sometimes expectations are heavily influenced by recent trends. When economic factors stay consistent for a long enough period of time, people tend to fall into a pattern of expecting these factors to remain in place. For example, they get used to ultra-low interest rates, or rising oil or a relationship between unemployment and inflation because it has been that way for an extended period of time, just like when people adjust to an odd smell in their home and do not even notice it, given enough time. This does not mean the environment, or the smell, is normal, people have just come to expect it. When the economic environment starts to change, people have varied reactions. For example, some people will assume it will revert to the recent patterns and others will become more uncertain about the future and move to safer havens being more willing to pay more for risk aversion. Rapid adoption of technology can cause these patterns to change quickly and investors have to try to calculate if new technology agents that have been introduced to the economy are destroying an old trend or not.

It is worth reviewing some of the historical discussion on expectation theories: One of the simplest expectation theories focuses on interest rates and forward interest rates. The pure expectation theory states that forward interest rates and the term structure of rates represent the combination of everyone’s expected future short-term rates. Therefore, if the aggregate view is that the short-term rates will be higher in the future the term structure of interest rates should rise over time.

The widely discussed rational expectations theory can claim many parents. The legendary John Maynard Keynes expressed the idea that profit expectations and the level of confidence that corporate management had in those expectations impacted the level of business investment. These views were also expressed by economists John Hicks and A.C. Pigou. John Muth outlined a more formal aspect of the rational expectations theory. This more carefully explains how producers and suppliers use past events to predict future business operations; this could also be applied to consumers. There has been significant research on the rational expectations theory since the 1960s. Some of the works done by Keynesian’s argued that people were very reactive to changes in their income or other facets of their economic well-being. This implied a drop in income for one year would increase a person’s expectations of volatility and would transmit to a drop in consumption. From this the economist Milton Friedman responded with the permanent income theory. Mr. Friedman suggested people make assumptions about their long-term income and smooth their consumption over time and for these reasons are not as reactive. Another theory has focused on adaptive expectations, which implies, among other things, that a piece of material new information, such as a drop in income, will not cause an immediate drop in consumption, nor will it be ignored and completely smoothed into a lifetime average. This information will cause a person to shift their expectations over time.

Rational expectations theory has been the basis from which much of the modern investment theory has evolved. Most notable is the efficient market theory. This theory outlines that the best guide to future asset values is present asset values. This is because all investors should look at all the available data, which will move everyone toward the same valuation for an asset and profit seeking investors will buy that asset until it reaches the correct price. A “strong” version of efficient market theory assumes equal amounts of information are available to all. A “weak” version assumes that some people do not have all the information or may not have the time to access all the information but they make rational decisions given limited information. The theory holds that when there are random disruptive events, valuations can change. Efficient markets theory is also tied to modern portfolio theories that incorporate concepts like the efficient frontier and measures of alpha and beta. Criticisms of rational expectations focus on the fact that people are often irrational and subject to biases. They may act in line with others or get excited about recent performance and develop irrational exuberance. Critics also cite that people don’t necessarily learn from past mistakes and tell themselves, “that it is different this time.” Ultimately much of the research on expectations theory has shown that, at the very least, people react differently to anticipated and unanticipated inflation, this may translate to other economic expectations as well.

The world today, of course, is changing how you must think about expectations. Much of the research done on expectations and modern investment theory is based on everyone in the market having equal access to all available information. There is a significant amount of work on the impact of market participants having symmetrical or asymmetrical information. The field is viewed as important enough that the 2001 Noble Prize in Economics was awarded to George Akerlof and Joseph Stiglitz for their work on the impact of asymmetrical information, even though Mr. Akerlof’s original paper on the topic was rejected by three academic journals.50 Today there may very well be a new kind of information asymmetry occurring in which there is so much information available that it is difficult to process it and those who can process more or select the right information to focus on have an advantage over those who can not. If this information processing asymmetry proves to produce different results, you could get more divergent market views and more variance in expectations and thus different reactions when results deviate from trend. Regulators (except for the MiFID II rules) have done a very good job at increasingly leveling the playing field for access to information for all investors, but with so much information, knowing how to prioritize it is increasingly important.

How the population changes will trigger different responses in expectations and reactions. A changing population will have experiences and biases that vary from the existing core of the population, these human variances can be more difficult to analyze in algorithms, especially as they evolve real time. The biggest example of this might be the large millennial population that will start to increasingly shift economic expectations. Their experiences with technology and the great recession will increasingly change the aggregate expectations in the economy.

Part of the theoretical work on expectations certainly veers into the areas of neuroscience and psychology. Much of the research in the area has focused on how much people’s views are determined by their experience and by their goal to maximize their utility, whether that utility is profit, happiness, or time sleeping off a drinking binge. If the outcomes do not differ too often from what people expect, many theories hypothesize that people will continue to trust their expectations and not revise their outlook considerably, therefore, changes in behavior will be minimal. There are occasional failings in this theory, but they are either outliers or people adjust to these changes and realign their expectations. When there is a big enough change to alter long-term expectations, asset valuations get reset. This reset factor may be interesting in the current environment, given the millennial population bubble consists of many people that for most of their investing life have been experiencing an economy impacted by post-great recession central bank policies that have created an extended period of low interest rates and inflation. If this environment changes dramatically it will be a new experience for a large portion of the population and they will need to reset expectations.

Expectations are massively important when making investments. Investors do not like uncertainty and when results vary from expectations, uncertainty increases. It is quite possible the composite expectations being used now are much weaker than in the past, primarily because of cut backs at banks and given that models may not be adapting as quickly as they should, given all the rapid changes in the economy. Surveys are an increasingly valuable tool to monitor the economy, given how quickly they can reflect new developments compared to some traditional economic reports. Consumer and business survey data can have numerous shortcomings, but this “soft” data may be more valuable in catching rapidly changing subtle shifts in consumer spending, business investment, and inflation trends than the much delayed “harder” government releases.

Selected Ideas from Part 4